AOL: Too Many Questions For A Sound Investment

| About: AOL Inc. (AOL)
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Back in December, I assumed that the next time AOL Inc. (NYSE:AOL) was in the spotlight would be to discuss its future bankruptcy, but instead the company is trading at 52-week highs and has returned 90% YTD. The stock has been on a tear, mostly due to its $1.056 billion patent transaction with Microsoft Corporation (NASDAQ:MSFT), which not only provided cash, but also led investors to wonder if perhaps there is more than meets the eye with AOL.

At first glance, AOL looks almost hopeless, as I do not consider any of its brands to be a market leader. Its core brand is far behind Google (NASDAQ:GOOG) and even Yahoo! (YHOO) in Internet search, and I've never known anyone to search for a job on AOL Jobs or search for a house on AOL Real Estate. Its music segments have been disastrous, no one uses it AOL Travel, and has been replaced and is almost extinct. By now you should get the picture.

As you search through each of AOL's brands you can't find one that is a leader or controlling any one particular space with enough conviction to support long-term growth. However, investors still believe there is some value to its stock.

I suppose the big question for AOL investors is whether or not AOL needs to control a particular space within the Internet to be relevant as a company. There is definitely two ways to look at the story: some suggest it was way undervalued from the start of 2012 and others believe its rally is undeserved and will result in significant loss for investors. I personally fell into the category of feeling as though investors were making a big mistake, but as I dug deeper I began to consider the possibility that perhaps it is undervalued as a company.

AOL trades with a forward P/E ratio of 33.00, which means its current ratio of 90 should diminish over the next year with strong earnings. The company also trades with a price/sales of just 1.22 with $2.18 billion in revenue, and a market cap of $2.7 billion. When you compare it to YHOO's $19.50 billion market cap, it looks cheap, especially considering that YHOO posted less than $5 billion in revenue over the last 12 months; therefore making it 85% larger than AOL in terms of sales, but valued more than 7x the market cap of AOL, which doesn't necessarily make sense.

Of course, there is more that goes into valuing a company than just sales. YHOO trades with a profit margin of 22.28%, while AOL is barely profitable with a profit margin of 1.35%, which explains the difference in value in a market that is primarily concerned with bottom line performance. However, my theory is and has always been that a company can always cut costs to improve margins, but that it is much more difficult to create sales. Therefore, I believe AOL presents much more upside in terms of being able to grow earnings without significant revenue growth, which it lacks.

In the end, the space belongs to Google and even Microsoft . AOL has dying brands, but could easily improve margins. AOL has very strong returns on operating activities, but has always failed to capitalize on investing and financing activities of its cash flow. Therefore, as long as the company can correct some of these mistakes its margins could rise, but it still must strive to become a leader in some area of its business.

As an investor there are way too many questions for me to feel comfortable with an AOL investment, however it does have strong sales, but nothing concrete that allows me to feel comfortable in knowing that the company will return strong gains for many years to come.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.